COMPANIES SAW PROBLEMS

'The story of the credit rating agencies is a story of colossal failure,' California congressman says at hearing

WASHINGTON – Executives and employees at the major credit ratings agencies were often aware of problems in the AAA grades awarded to thousands of mortgage-related securities whose downgrades helped plunge the nation into a financial meltdown.

At the same time, according to documents from the big credit ratings agencies presented at a House hearing yesterday, pressure from bond and securities issuers translated into inflated ratings that put investors at risk. The companies – Standard & Poor's, Moody's and Fitch Inc. – made enormous profits as they evaluated a ballooning number of mortgage-backed bonds, many of which were given top marks as long as housing prices went up.

In a presentation made to the Moody's board of directors a year ago, top executive Raymond McDaniel warned that company employees sometimes “drink the Kool-Aid” and gave in to pressure for undeservedly high ratings, even as the weaknesses of the mortgage backed securities were becoming apparent.

The executive also warned that the issuers of mortgage-related securities awarded business to companies that produced inflated assessments and that other participants in the market wanted them as well.

“The story of the credit rating agencies is a story of colossal failure,” said Rep. Henry Waxman, chairman of the House Oversight and Government Reform Committee.

The California Democrat said, “Millions of investors rely on them for independent, objective assessments. The rating agencies broke this bond of trust, and federal regulators ignored the warning signs and did nothing to protect the public. The result is that our entire financial system is now at risk.”

The executives of the big credit ratings agencies testified that virtually no one predicted the plummeting values in the housing market and mortgage-related securities. They were caught unprepared when housing prices fell and their ratings models proved flawed.

“It is by now clear that a number of the assumptions we used in preparing our ratings on mortgage-backed securities issued between the last quarter of 2005 and the middle of 2007 did not work,” Standard & Poor's chief executive Deven Sharma said.

The companies are important because their high assessments assured investors that their money should be safe. The inflated ratings awarded to securities backed up by subprime loans led investors to buy them in enormous numbers. But now, most of these securities have been downgraded and the market for them has largely evaporated, contributing to the current crisis.

“Like the 'UL Approved' tag on electric appliances, an AAA credit rating is meant to insulate investors against nasty shocks,” said top panel Republican Tom Davis of Virginia. “But as the collapse of the mortgage-backed securities boom has seen billions in once high-grade investments fall quickly to junk status, many are asking how and why the . . . credit rating agencies got it so wrong.”

A Standard & Poor's spokesman said lawmakers exaggerated the percentage of mortgage-backed securities that had to be downgraded and noted that none of the $855 billion worth of AAA subprime mortgage-backed securities that it graded over 2005-07 had gone into default.

Still, a 2007 internal exchange by two Standard & Poor's employees shows how the analysts worried that the company's models didn't accurately capture the riskiness of some securities.

“It could be structured by cows and we would rate it,” one analyst said.

In another internal exchange, a Standard & Poor's analyst in 2006 told a co-worker, “Let's hope we are all wealthy and retired by the time this house of cards falters.”

Company executives were well aware that there was often little basis for giving AAA ratings to increasingly complex securities but that companies often vouched for them anyway.

“Fitch and S&P went nuts. Everything was investment grade,” McDaniel told a gathering of Moody's employees last September. “We tried to alert the market. We said we're not rating it. This stuff isn't investment grade. No one cared because the machine just kept going.”